Occupants of commercial real estate, also referred to as users or occupiers, fall into two categories: tenants or owners.
Since both are tenants, I’ll draw a finer distinction, noting that one genre pays rent to an unrelated third party, the landlord, while the other pays rent to a related owner of the building.
The most common in the second type is a real estate ownership structured as a limited liability company and the occupier a corporation.
Today, I want to focus upon some common mistakes I witness occupants make in their commercial real estate decisions.
No agreements
Too frequently, I see this with occupants whose building ownership is synonymous with that of the operation.
A building is purchased, many times with debt, and a mortgage payment is originated. Additionally, property taxes, insurance and maintenance are incurred. That payment becomes rent, which ownership charges the occupant.
Unfortunately, the payment has no relation to a market rent for a comparable building. The owner has her costs covered and believes everything is golden.
A subsidy as such — charging the company less than market — devalues the operation. If a market rent was charged, a deduction in profit results.
Conversely, charging too much places undo strain on the occupant and ready sources of capital are consumed. This can limit the ability to hire, buy machinery and grow sales.
Once a satisfactory market rent is determined, it’s critical to have a written agreement between the parties outlining the rent, expenses, term, increases and options.
I once had a client forced to move because no written agreement existed between the owner and occupant. Unbeknownst to the occupant, the owner had deeded small portions of the building ownership to various entities, such as ex-wives, charities, ex-girlfriends and the like.
When the owner met his untimely demise, the occupant — who was also a part-owner of the building — found himself without an agreement and many factions wanting their equity.
A trustee was appointed to sort out the mess. The trustee’s only course of action was to sell the building and force the tenant to relocate. Extreme, but it can happen.
Extension rights
Extension rights fall in to numerous categories including options to renew a lease term, options to purchase the building, options to terminate the lease, options to take additional space, rights of first refusal to purchase and lease, as well as rights of first refusal and rights of first offer to purchase the real estate.
Clearly, these understandings must be in writing in order to avoid conflict. However, one of the problems I see is the agreements are too vague.
As an example, maybe an occupant has the option to renew the term of their lease for five years at the expiration of the original lease term. If the language simply says an occupant can stay for an additional five years at a mutually agreeable rate, disagreements can occur — because no mechanism exists to determine a fair rental rate.
Therefore, it’s important for options to not only be in writing, but also have clear definitions as to how rents and purchase prices are to be calculated.
I’m involved in one such exercise now in which the language is very specific. If the landlord and tenant cannot agree upon a rate, each appoints an arbiter to make an independent evaluation of the market.
If those two arbiters cannot come to an agreement, a third arbiter is appointed by the previous two, and her determination is final. This is a cumbersome process, but one which will avoid any disagreement.
Finally, make sure the market lease rate or market purchase price is based on comparable buildings within a comparable submarket with similar amenities. In other words, it’s unfair to compare a 4,000-square-foot property in the Irvine Spectrum area to a 100,000-square-foot building in Santa Fe Springs.
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104.
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